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Overview and Risks of Options Trading

Have you lost some, if not all of your investment portfolio in trading options? If so, the attorneys at The White Law Group may be able to assist you in recovering your investment losses. Due to the complexity and risks, options trading is not appropriate for all investors.

What is Options Trading?

Options are a type of derivative security. Options, which are essentially a contract, allow you to trade on the future value of an underlying market.

There are two types of Options — puts and calls. The set price that the option refers to is called a strike price. There are several factors that will impact price of an option – the level of the underlying market compared to the strike price, the time the option has left before expiration, and the underlying volatility of the market. Options give you the right, but not the obligation, to buy or sell at a set price on or before a certain date. One option equals 100 shares of stock.

Options are available for short and long-term trading. Offers range from daily, which would expire at the end of the underlying market on the particular day you place the trade, to weekly, monthly, and quarterly.

Breakdown of Options Strategies

Covered Call

A covered call is when the investor sells a call option and owns the shares being optioned. Covered calls are for beginners who are just getting started investing in options. They have the same risk as a short put with a bullish assumption. A covered call is when the investor owns a naked stock (a stock without any options on it), and it must go up to be profitable. When a call is sold against the shares, this reduces the cost basis. Now the stock can stay the same and the investor would receive the premium paid for the option as long as the stock stays out of the money, or the stock could drop a little and would still be profitable due to the premium paid.

Naked Call

A naked call on the other hand, is the opposite of a covered call. A naked call is a put option where the stocks are not owned or the asset that is being optioned. The seller in the naked call hopes the underlying equity or stock stays relatively the same or rises modestly. In this case the seller will retain the premium paid. This becomes a riskier position when the seller does not have sufficient funds to cover the purchase of the underlying equity.

Protective Put

This strategy is where an investor buys shares of an asset or stock, and at the same time enough put options to cover those shares. In steadiness this strategy will have the same net payoff as buying a call option.

Bear Put Spread

This strategy is a vertical spread strategy. Investors will instantaneously purchase put options at a specific strike price and sell the same number of puts at a lower strike price. Both contracts would be for the same asset and have the same expiration date. This is used when the trader is bearish and expects the assets market value to diminish. This method offers both limited gains and losses.

Bull Call Spread

In this strategy, an investor will instantaneously purchase a call option at a specific strike price and sell the same number of calls at a higher strike price. Again, both contracts will have the same expiration date. This strategy is often used when an investor is bullish and expects a reasonable rise in the price of the asset.

Long Straddle

This strategy comprises purchasing both a call and put option on some interest rate, index, or other underlying. The two options are bought at the same strike price and expire at the same time. The owner of a long straddle makes a profit if the underlying price moves a long way from the strike price, ether above or below. Thus, an investor may take a long straddle position if he/she thinks the market is highly volatile but does not know which direction it is going to move. This position is a limited risk, since the most a purchaser may lose is the cost of both options. At the same time, there is unlimited profit potential.

Long Strangle

This strategy involves going long; buying both a call and put option of the same security. Like a straddle, the option expires at the same time, but unlike a straddle, the options have different strike prices. A strangle can be less expensive than a straddle if the strike prices is out-of-the-money. The owner of a long strangle makes a profit if the price moves far enough away from the current price, either above or below. Thus, an investor may take a long strangle position if he/she think the underlying securities is highly volatile but does not know which direction it is going to move. This position, just like the long straddle, is a limited risk, since the most a purchaser may lose is the cost of both options. At the same time, there is unlimited profit potential.

Butterfly Spread

Additionally, a butterfly spread is a limited risk, non-directional options strategy that is designed to have a high likelihood of earning a limited profit when the future volatility of the primary asset is expected to be lower or higher than the implied volatility when long or short respectively.

Iron Condor

The iron condor is an option trading strategy utilizing a combination of two other options, put spread and call spread. Both put and call spread will have the same expiration date and four different strikes. The iron condor is selling both sides of the asset by simultaneously shorting the same number of calls and puts, then covering each position with the purchase of further out of the money call(s) and put(s) respectively.

Iron Butterfly

Alternatively, the iron butterfly, also known as the ironfly, is a strategy that involves buying four different contracts at three different strike prices. It is a limited risk, limited profit trading strategy that is structured for a larger probability of earning smaller limited profit when the asset is perceived to have low volatility.

Primary Broker Abuses & Warning Signs

The following are warning signs that your broker may not have your best interests in mind.

If you are receiving a frequent amount of buy/sell confirmations, your broker may be churning your account. This is the primary retail risk posed by options trading.

If your broker is avoiding your calls or not responding to your emails in a timely manner, or doesn’t call you prior to making trades, that is another warning sign.

Trading on margins is another red flag. Trading on margins means you are taking out a loan from the brokerage firm to invest in more securities than you can buy with your available cash. Not only are you risking cash you do not currently have, which is also known as gambling, you are also paying interest on the same funds.

Similarly, if your broker suggests taking a 2nd mortgage on your home to invest, that would be a warning sign that he or she is not looking out for your best interest.

Ask detailed questions and don’t turn a blind eye, you are your own best advocate.

Overview of FINRA

The Financial Industry Regulatory Authority (FINRA) regulates the securities industry. Its entire purpose is to provide investor protection and promote market integrity through effective and efficient regulation of broker-dealers.

According to FINRA’s proposal released in April 20, 2018, the regulator would no longer require that a broker control a client’s account in order to find that the broker has churned it.

Under current rules a broker can only be found liable for churning if he or she has discretion. FINRA is constantly evolving to better suit the investors and ultimately keep the playing field fair.

Free Consultation

If you believe you have suffered financial losses due to options trading with your investments, the attorneys at The White Law Group may be able to help you recover your investment losses. Please call our offices at (888) 637-5510 for a free consultation with a securities attorney.

The White Law Group is a national securities arbitration, securities fraud, and investor protection law firm with offices in Chicago, Illinois, and Vero Beach, Florida.